This paper extends research investigating the persistence and market pricing of earnings components. Sloan [1996] separates earnings into cash and accrual components and finds that the cash component has greater persistence than the accrual component, investors inefficiently treat both components as having similar persistence characteristics and, therefore, the stock market underreacts to the persistence of cash earnings and overreacts to the persistence of accruals. Xie [2001] further disaggregates accrual earnings into normal and abnormal components and finds that abnormal accruals drive the accrual anomaly discovered by Sloan.
Dechow, Richardson and Sloan [DRS 2008] more precisely define total accruals as the income effects of changes in non-cash operating asset and liability accounts and free cash flow as the difference between total earnings and accruals. Furthermore, DRS disaggregate free cash flow into net changes in the firm?s cash balance (including short-term investments and other financial assets) and net distributions to providers of capital. DRS find that changes in the cash balance have similar persistence characteristics as accruals and that the market similarly overreacts to the persistence of both accruals and changes in cash.
Our paper further analyzes the primary DRS finding. We investigate the characteristics of changes in cash that create persistence characteristics similar to accruals. In particular, as explained in more detail below, we disaggregate changes in cash into a normal (precautionary) component and an abnormal component that can be positive or negative and, respectively, creates either excess or insufficient cash on hand. Following DRS, we apply the Mishkin [1983] approach in our evaluation of market efficiency.
We extend DRS by evaluating market efficiency with respect to the persistence of seven earnings components: total accruals and free cash flow, disaggregated into net distributions to debt holders, net distributions to equity holders, normal changes in cash, positive abnormal changes in cash, and negative abnormal changes in cash. Our disaggregation of changes in cash follows recent developments in finance literature estimating optimal cash balances (e.g., Opler et al. [1999]; Bates, Kahle and Stulz [BKS 2009]).
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Earnings Persistence and Mispricing Implications of Abnormal Changes in Cash
